An overview of Transfer Pricing Vispi T. Patel Vispi T. Patel & Associates March 14, 2015 1
Agenda Transfer Pricing Origin, Evolution and Basic Concepts TP Indian Perspective Indian Transfer Pricing Regulations v OECD TP Guidelines Nuances Case Study 2
Transfer Pricing (TP) Origin, Evolution and Basic Concepts 3
Origin of Arm s Length Standard The arm s length standard (ALS) was initially stated in the earliest U.S regulations under Section 482 of Internal Revenue Code (the code) issued in 1934 The United States was prime promoter of adoption of the standard in OECD Model Tax Convention released in 1963 The 1979 OECD Report focused on arm s length standard and set forth the appropriate methodologies to be used to achieve arm s length result The 1995 / 2010 OECD Transfer Pricing Guidelines for Multinational Enterprises (MNEs) and Tax Administrations (OECD TP Guidelines) reaffirmed the status of arm s length standard as the international standard 4
Evolution - OECD s View Transfer Pricing can deprive governments of their fair share of taxes from global corporations and expose multinationals to possible double taxation. No country poor, emerging or wealthy wants its tax base to suffer because of transfer pricing. The arm s length principle can help. By John Neighbour Organisation for Economic Co-operation and Development OECD Centre for Tax Policy and Administration 5
Evolution of TPR Foundation of the Transfer Pricing Regulations are embedded in the Double Taxation Avoidance Agreement ( DTAA ) Article 9 of the OECD Model Convention The OECD Report on Transfer Pricing Guidelines for MNEs and OECD TP Guidelines are the foundation for transfer pricing regulations in India Based on Arm s Length Principle The universal principle which is the foundation of TP legislation globally Above principles serve the dual objectives - Securing the appropriate tax base in each jurisdiction and avoiding double taxation 6
Transfer Pricing (TP) Indian Perspective 7
Brief History & Background of Indian TPR Liberalization of trade and foreign exchange policy started in India in the year 1991 This created huge increase in interest of MNEs in India Several Indian companies also steadily emerged as global players by either making offshore acquisitions or by setting up overseas subsidiaries Evaluation of the price charged by one related party to an other related party for goods, services, etc.; 8
Brief History & Background of Indian TPR The Standing Committee in March 1991 observed that provisions of Income-tax Act, 1961 (Act) were inadequate to curb transfer pricing among MNEs Objective of the Revenue is to check erosion of the tax base and plug the leakage of the revenue; 9
Brief History. The Expert Group constituted by Central Board Of Direct Taxes (CBDT) recommended complete revision of the existing section 92 of the Act The Finance Act, 2001 introduced TPR in India by substituting existing Section 92 of the Act and introducing new sections 92 to 92F w.e.f April, 2001 The Finance Act, 2012 amended TPR for domestic transactions w.e.f AY 2013-14. This was an outcome of suggestions given by Honorable SC in CIT v Glaxo SmithKline Asia (P) Ltd. (236 CTR 113) 10
TPR in India Section 92-Income arising to Associated Enterprises from International Transactions (or Specified Domestic Transactions w.e.f AY 2013-14) shall be computed having regard to the Arm s Length Price (ALP) OECD TP Guidelines have laid the foundation of the Transfer Pricing Regulations in India Preconditions: Two or more associated enterprises Enter into an international transaction Specified Domestic Transaction (w.e.f. AY 2013-14) Consequence: Income/ Expenditure to be computed having regard to the arm s length price 11
Arm s Length Price Section 92F(ii) of the Indian TPR arm s length price means a price which is applied or proposed to be applied in a transaction between persons other than associated enterprises, in uncontrolled conditions Under Rules 10A to 10E of Income-tax Rules, 1962 (Rules); Uncontrolled transaction transaction between enterprises other than associated enterprises, whether resident or non-resident 12
Associated Enterprises as per Indian TPR [Section 92A] Means direct or indirect participation in management control or capital: by one enterprise into another enterprise; or by the same person in both the enterprises Equity holding, Control of Board of Directors / Appointment of one or more Executive Director, mutual interest will also constitute Associated Enterprise Either or both of Associated Enterprises should be a non-resident 13
Meaning of AEs.. Deemed Associated Enterprises includes: Holding of 26% of voting power by one enterprise into another enterprise; or by the same person in both the enterprises Dependence on intangible assets Purchase of 90% or more of raw materials and consumables Sale of goods influence on price and conditions of supply by buyer Control by individual or his relative Financial transaction Loan - 51% or more of book value of total assets of the borrowing enterprise Guarantee - 10 % or more of the total borrowings of an enterprise 14
Associated Enterprise.. Term of wide import Following parties also covered: Venture Capital investors with 26% stake FI s advancing loans exceeding 51% stake of assets of borrowing enterprise Franchisers, licensees, technical collaborators, etc Is your company covered? 15
Meaning of AEs as per OECD Model Tax Convention Article 9(1) of OECD Where direct or indirect participation in management, control or capital: by one enterprise into another enterprise; or by the same person in both the enterprises then any profits which would accrue to either one of enterprises but have not accrued due to controlled conditions will be included in profits of that enterprise and taxed accordingly Whether definition of AE under domestic law can be reduced in rigor by falling under relevant article of AE under the treaty? 16
International transaction Means transaction between two or more Associated Enterprises: Transaction between two or more associated enterprises (at least one of which will be non-resident) of purchase, sale or lease of tangible and intangible property, provision of services, financing, cost sharing / cost contribution arrangements OR Any other transactions affecting profits, losses, income, assets or liability of the enterprise 17
International Transactions (Amendments by Finance Act, 2012) The expression International Transaction was amended by Finance Act, 2012 w.e.f 1.04.2002 to specifically include: Inter-company Guarantees, Advance payments, deferred payments, receivables, Capital Financing/ Business restructuring / reorganisation, Purchase / sale/ use of intangibles such as customer lists, customer contracts, customer relationships, Transfer / secondment of trained employees, etc. 18
Definition of Deemed International Transaction (Amendments by Finance Act, 2014) The Finance Act 2014, has broadened the scope of international transaction. Further, the amendment is effective from 1 April 2015 Where a transaction is entered into by an enterprise with a person other than an AE and There exists a prior agreement in relation to the relevant transaction between such other person and the AE or, Terms of the relevant transaction are determined in substance between such other person and the AE, and Either the enterprise or the AE or both of them are non-resident whether or not such other person is a non-resident Such transaction will be deemed to be an international transaction 19
Definition of Deemed International Transaction Outside India India Indian Co. (Enterprise) Foreign Co (AE) Transaction Prior agreement Unrelated Customer Deemed International Transaction 20
Definition of Deemed International Transaction The Hyderabad Tribunal in the case of Swarnandhra IJMII Integrated Township Development Co. P. Ltd vs. DCIT [2013-TII-152-ITAT-HYD-TP] held that deeming fiction does not cover transactions between two Indian entities Similar position taken in Kodak India Pvt Ltd (155 TTJ 69) (Mum ITAT) and Vodafone India Services Pvt Ltd (Bom HC) (262 CTR 153) 21
Specified Domestic Transactions The Finance Act,2012 has introduced TPR for specified domestic transactions under Section 92BA Specified Domestic Transactions to include : Expenditure in relation to which payment has been made to related party as specified in Section 40A(2)(b) Transfer of goods or services between two units, undertakings or companies which are related and one of them is eligible to avail deduction under Chapter VI-A, 80IA Any transaction in Chapter VI-A or Section 10AA to which the transfer pricing clause under section 80IA are specifically made applicable Any other transaction as may be prescribed 22
Applicability to Domestic Transactions w.e.f AY 2013-14 Assessees have to file Form no. 3CEB in respect of Specified Domestic Transactions entered into with their related parties Minimum Threshold: INR 50 millions. Further, vide the Finance Bill, 2015 it is proposed to raise the threshold limit to 200 millions w.e.f. AY 2016-17 May amount to double taxation in certain cases All existing TP compliance requirements, mandatory documentation, TP audits (assessments) and penalty provisions will be applicable 23
Most Appropriate Method (MAM) The Act prescribes selection of the MAM from the six specified methods; having regard to the nature of transaction or class of transaction or class of associated persons or functions performed by such persons or such other relevant factors as the Board may prescribe The Six methods: a) Comparable Uncontrolled Price Method (CUP) b) Resale Price Method (RPM) c) Cost Plus Method (CPM) d) Profit Split Method (PSM) e) Transaction Net Margin Method (TNNM) f) Rule 10AB -Any other method prescribed by CBDT 24
Arm s Length Standard and Arm s Length Price The Arm s Length Standard (ALS) is the Universal Standard that is applicable to the various intra-group transactions of a MNE. It is based on the separate entity approach and is enshrined in the DTAAs signed by the various countries The same principle also applies to specified domestic transactions The ALP under Section 92F of the Act denotes price which is applied or proposed to be applied in a comparable transaction between unrelated independent parties in uncontrolled conditions Usually corresponds to the open market price 25
Transfer Pricing Adjustment Absence of arm s length price in international transaction, or failure to maintain the prescribed documentation, or use of unreliable data can lead to adjustment Arithmetic mean vs. Range of results Tax exemption will not be available for the amount of adjustment (10A, 10AA, 10B, Chapter VI A) 26
Transfer Pricing Assessments -TPA The revenue authorities across the globe in their wanting to safeguard their country s tax base, require strict compliance from the taxpayers to the TP rules and regulations 27
TPA.. Documentation is the key to demonstrate adherence to the Arm s Length Standard 28
Documentation..Seven steps Approach Understanding the Business Model of the Corporate Body Analyzing the Transaction(s) Functional & Economic analysis Assessment of comparables Selection and application of methodology Benchmarking the transaction Reviewing the process 29
Documentation Requirements - Rule 10D(1) This is the mandatory documentation required by law a. Description of Ownership Structure (Step I) b. Profile of Multinational Group (Step I) c. Description of Business (Step I) d. Nature & Terms of Transactions (Step II) e. Description of Functions, Risks & Assets (Step III) f. Record of Economic & Market Analyses, if any (Step III & IV) 30
Documentation Requirements.. g. Comparability Analysis (Step IV) h. Record of Uncontrolled Transactions (Step VI) i. Description of Methods considered (Step V) j. Record of Actual working (Step VI) k. Assumptions, policies, price negotiations, if any (Step II & III) l. Any other information, data or document (Company specific information, if any) 31
Advance Pricing Agreements (APA) The Finance Act, 2012 introduced APA Mechanism Salient Features Seeks to provide assurance of certainty and unanimity in transfer pricing approach followed by the tax authorities and taxpayers Validity: Upto subsequent five years and four previous years (Rollback proposed vide the Finance Act, 2014) Binding on tax authorities as well as taxpayers unless there is a change in the law or facts of the case Pre Consultation process (with anonymous application option) 32
APA Following are important points to be considered: Each year Annual Compliance Report in Form No. 3CEF needs to be filed before DGIT (IT) The APA can be cancelled/revised if critical assumptions are violated or conditions are not met, subject to which the agreement has been entered into If the Compliance Audit results in a finding that the assessee has failed to comply with the terms of the agreement, the agreement can be cancelled Non filing of Compliance Report or the report contains material errors, it may result in cancellation of the agreement 33
Safe Harbour Rules Safe Harbour provisions were introduced in the Finance Act, 2009 in order to reduce transfer pricing disputes, however, no rules were prescribed to the effect CBDT released final Safe Harbour Rules on 18 th September 2013, as regards various financial parameters for the prescribed sectors/activities performed by an eligible assessee 34
Summary of Safe Harbour Rules Safe Harbour Rules Eligible international transaction Threshold limit prescribed Safe Harbour margin Provision of software development services (other than contract R&D) and information technology enabled services Provision of knowledge process outsourcing services Interest on advancing of intra-group loans Providing corporate guarantee (other than comfort letter, performance guarantee, etc.) INR 500 crores or less Above INR 500 crores None Loan amount INR 50 crores or less Loan amount more than INR 50 crores INR 100 crores or less Above INR 100 crores* 20 percent or more of Operating Costs 22 percent or more of Operating Costs 25 percent or more of Operating Costs SBI base rate + 150 basis points SBI base rate + 300 basis points 2 percent p.a. or more 1.75 percent p.a. or more *Credit rating done by an agency registered with SEBI, is of the 35 adequate to highest safety
Summary of Safe Harbour Rules Eligible international transaction Safe Harbour Rules Provision of contract research and development services wholly or partly relating to software development Provision of contract research and development services wholly or partly relating to generic pharmaceutical drugs Manufacture and export of core auto components Manufacture and export of non-core auto components 30 percent or more of Operating Costs 29 percent or more of Operating Costs 12 percent or more of Operating Costs 8.5 percent or more of Operating Costs 36
Summary of Safe Harbour Rules Procedural Aspects Eligible taxpayers must furnish a self-attested form i.e. Form No. 3CEFA, containing various details of the eligible transactions on or before the due date for filing the income tax return The Assessing Officer may make a reference to the Transfer Pricing Officer to verify the validity of option exercised by the taxpayer Various other procedural aspects have been provided by the relevant Rules 37
CBDT notifies amendment in Rule 10D and Safe Harbour Rules for Specified Domestic Transactions The CBDT via Notification No.11/2015/F.No.142/7/2014-TPL]dated 3 rd February 2015: Eligible assessee A person who has exercised a valid option for application of safe harbour rules in accordance with the provisions of rule 10 THC, and Is a Government company engaged in the business of generation, transmission or distribution of electricity Eligible specified domestic transaction (SDT) Means a SDT undertaken by an eligible assessee and comprises of :- 1. Supply of electricity by a generating company; or 2. Transmission of electricity; or 3. Wheeling of electricity 38
CBDT notifies amendment in Rule 10D and Safe Harbour Rules for Specified Domestic Transactions Safe Harbour Rule The tariff as determined by the Appropriate Commission in accordance with the provisions of the Electricity Act, 2003 (36 of 2003) Appropriate Commission Section 2(4) of the Electricity Act, 2003 (36 of 2003) An appropriate commission shall be a Commission to be known as the Central Electricity Regulatory Commission to exercise the powers conferred on, and discharge the functions assigned to it under the Electricity Act Government company Section 2(45) of the Companies Act, 2013 (18 of 2013) Any company in which not less than fifty one per cent of the paid-up share capital is held by the Central or State Government partly or fully and includes a subsidiary company of such a Government company Procedural Aspects Eligible taxpayers must furnish a self-attested form i.e. Form No. 3CEFB, on or before the due date for filing the income tax return Various other procedural aspects have been provided by the relevant Rules 39
Indian TPR v OECD TP Guidelines 40
Multiple Year Data OECD Guidelines allow taxpayers the use of multiple year data as it generally captures market & business cycles and smoothens effects of yearly aberrations giving a better overall statistical result However Indian TPR are counter intuitive and go against the international consensus by rejecting multiple year data generally 41
Use of Foreign Comparables OECD Guidelines, in principle, recognize the use of foreign comparable by making suitable adjustments if there is material effect on price due to geographical differences Indian TPR do not specifically prohibit foreign comparables However revenue authorities have been reluctant to use overseas comparable laying strong preference for Indian comparables In Global Vantedge India (P) Ltd v DCIT the Delhi Bench of tribunal rejected selection of foreign party as tested party as geographical differences would make it difficult to establish comparability Further, in Onward Technologies Limited v DCIT the Mumbai Bench of tribunal has also rejected the selection of foreign party as tested party In Ranbaxy Laboratories v ACIT the Delhi bench of tribunal accepted the use of foreign comparables as tested party. Further, the same has been accepted in Mastek Limited v ACIT and in AIA Engg. Ltd v ACIT, the Ahmedabad bench of tribunal 42
Transfer Pricing Methods OECD has historically preferred traditional methods viz. CUP, RPM, CPM over transactional profit method viz. PSM and TNNM, Rule 10AB Any other method However OECD s position has undergone a change in OECD TP Guidelines of July 2010, wherein OECD has treated all methods at par and has recommended the use of MAM applicable 43
Transfer Pricing Methods Thus OECD has in spirit accepted the Indian TPR s methodology to accept MAM, without laying emphasis on any particular method But underlying preference for CUP can still be gathered from the revised OECD Guidelines Even though Section 92C of Indian TPR do not prescribe preference over any particular method, tribunals in the following cases have laid down preference on traditional methods over transactional profit methods a) ACIT v MSS India (P.) Ltd [Pune ITAT] b) Serdia Pharmaceuticals Pvt Ltd v ACIT [Mumbai ITAT] c) ACIT v Sonata Software Ltd [Mumbai ITAT] d) M/s. Twilight Jewellery Pvt. Ltd v DCIT [Mumbai ITAT] 44
Range v Mean The OECD TP Guidelines allow for a range of comparable data However proviso to section 92C require computation of arithmetic mean (AM) if more than one price is determined by MAM The second proviso to Section 92C says that there will be no adjustment if variation between AM and international transaction or specified domestic transaction does not exceed; 1% for wholesale traders, and; 3% in all other cases Can all taxpayers conduct business transaction at a single mean price? 45
1%/3% arm s length range retained Wholesale Trading defined The CBDT via Notification No.45/2014/F.No.500/1/2014-APA-II]dated 23 rd September 2014: retained transfer pricing variation range, i.e. 1% in case of wholesale trading and 3% in other cases from the transaction price for international transactions and/or specified domestic transactions entered during financial year 2013-14 as well; Also defined the term wholesale trading i.e. Purchase cost of finished goods is eighty percent or more of the total cost pertaining to such trading activities; and, Average monthly closing inventory of such goods is ten percent or less of sales pertaining to such trading activities Whether Purchase cost shall mean price paid or it shall also include other incidental charges like custom duty or freight inwards etc.? Whether Total cost pertaining to such trading activities shall only be a sum of all operating costs or it shall also include financial costs pertaining to trading activity? 46
Nuances 47
Risk of Economic Double Taxation Transfer Pricing involves taxation of the same economic transaction both income and / or capital in the hands of two different tax payers in different countries Hence risk of double taxation is the biggest problem arising from TPR A proposed adjustment will lead to taxation of income earned by foreign AE in its jurisdiction of residence, while same income may be taxed in the hands of the other AE in a foreign jurisdiction 48
Toll Global Forwarding India Pvt. Ltd. [ITA No. 5025/Del/10] Delhi Tribunal Company is a joint venture between BALtrans International (BVI) Limited (holding 74%) and Kapil Dev Dutta (holding balance 26%); primarily engaged in the business of freight forwarding through air and ocean transportation Profits earned, after deducting transportation costs, in respect of import and export of cargo, are shared equally between the assessee and its AEs or independent third party business associates, as per the global practices in the industry In the transfer pricing study report submitted, the assessee adopted the Comparable Uncontrolled Price (CUP) Method for determining arm s length price 49
Toll Global. The TPO contented that the CUP Method chosen for both imports and exports has not been demonstrated It was also stated that even if the international transactions were to be analyzed by CUP Method, the assessee would be required to furnish the documents/vouchers related to third party for export and import transactions related to controlled and uncontrolled transactions The TPO selected TNMM as the most appropriate method and proceeded to make an addition to the international transaction 50
Toll Global. Observations of the Tribunal Transfer pricing should not be viewed as a source of revenue It is an anti-abuse measure in character and all it does is to ensure that the transactions are not so artificially priced, with the benefit of inter se relationship between associated enterprises, so as to deprive a tax jurisdiction of its due share of taxes Limitations of the prescribed methods of ascertaining arm s length price should not be allowed to come in the way of substantive justice, particularly when it is beyond reasonable doubt that there is no influence of intra AE relationship on the determination of prices in respect of intra AE transactions 51
Toll Global. The connotations of price, as set out in Rule 10B(1)(a) are required to be taken to be something much broader than the expression amount Further, Rule 10B(1)(f) inserted vide notification dated 23rd May 2012 is not a residual method As Rule 10BA, confers the benefit of an additional method of ascertaining arm s length price and, inter alia, relaxes the rigour of CUP method, it can only be retrospective in effect Considering all of the above observations, ITAT concluded that the business model adopted by the assessee, in principle, meets the test of arm s length price determination under Rule 10BA as well 52
Benchmarking Split of Contract Revenue 53
Facts of the Case Business Structure A Co.US B Co. UK Outside India 26% Share holding In India C Co. 54
Facts of The Case Original Contract - Value Rs.100 Third party client Background B Co. identifies and pursues potential clients for C Co. and enters into a contract with them for provision of ITeS Customer revenue passed to C Co. India on a backto-back basis (Rs.95) B Co. UK C Co. India Marketi ng fees 5% (Rs.5) B Co. enters into back to back contract with C Co. C Co. renders ITeS services to the ultimate clients B Co. passes on revenue received from clients to C Co. after retaining 5 percent of contract revenue towards marketing efforts, co-ordination, client liaising and credit risk. 55
Facts of The Case Net Profit on Contract Particulars B Co.UK C Co. Ind Sales 1000 950 Direct Cost Technical consultant cost (C Co.) 950 - Other Direct cost 40 800 Gross Margin 10 150 Other Indirect Operating Cost 15 100 Net Profit / (Loss) (5) 50 NPM (%) on sales (0.5) 5.26 56
Benchmarking As regards to the contract revenue, contract revenue is passed by B Co. to C Co. on back-to-back basis after retaining 5 percent On 5 percent retained by B Co., B Co. is earning negative net margin of 0.5 percent on contract revenue. Hence, C Co. contended that transaction is at ALP If Indian entity is making profit & its AE is making loss on given transaction, can it be claimed that revenue split is rational and transaction is at ALP?? OR Is that loss of AE is to be benchmarked to show that profit earned by Indian entity is at ALP? 57
Emerging international tax issues and effect on tax policies Increasing concern for both developed and developing countries on base erosion and profit shifting (BEPS), double non-taxation Impact of BEPS report and other changes on existing structures and proposed commercial transactions 58
BEPS Action Plan Action 1 : Addressing the tax challenges of the digital economy Action 2: Neutralising the effects of hybrid mismatch arrangements Action 3: Strengthen CFC rules Action 4: Limit base erosion via interest deductions and other financial payments Action 5: Countering harmful tax practices more effectively, taking into account transparency and substance Action 6: Preventing the granting of treaty benefits in inappropriate circumstances Action 7: Prevent the artificial avoidance of permanent establishment status Action 8: Transfer pricing aspects of intangibles Action 9: Consider transfer pricing for risks and capital Action 10: Low valueadding intra-group services Discussion Draft Action 11: Establish methodologies to collect and analyse data on BEPS and actions addressing it Action 12: Require taxpayers to disclose their aggressive tax planning arrangements Action 13: TP Documentation and Country-by-Country (CbC) reporting Action 14: Making dispute resolutions more effective Action 15: Developing a multilateral instrument to modify bilateral tax treaties 59
Action 13 TP Documentation and CbC Reporting Three Tier documentation structure proposed for all countries Template for master file To provide the MNE s blueprint Template for local file To provide material transfer pricing positions of the local entity/ taxpayer with its foreign affiliates Country-by- Country (CbC) Report The group s organisation structure A description of the group s business, intangibles, intercompany financial activities and financial and tax positions Demonstrates arm s length nature of transactions Contains the comparable analysis Jurisdiction-wise information on global allocation of income, taxes paid/ accrued, the stated capital, accumulated earnings, number of employees and tangible assets Entity-wise details of main business activities which will portray the value chain of inter-company transactions 60
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